The Truth about Fannie Mae and Freddie Mac

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Mend, Don’t End, Fannie and Freddie

Conservatives blame the mortgage giants (wrongly) for the financial crisis, and both parties want them dead. But to finish the job of financial reform without destroying the housing market and costing taxpayers billions, we need to let them live.

By Bethany McLean March/April/May 2016

It’s been almost a decade since the slow-rolling financial crisis, which reached its grand finale in the fall of 2008, got started. But as the response to The Big Short, the Academy Award-nominated film about the crisis based on Michael Lewis’s book of the same name, shows, there’s still a big fight about what actually went wrong. Some on the right wing immediately decried the movie, which focused on Wall Street’s greed, for ignoring the problems with government policies encouraging homeownership—specifically, the role of the so-called government-sponsored enterprises (GSEs), the Federal National Mortgage Association and the Federal Home Loan Mortgage Association, better known as Fannie Mae and Freddie Mac.

While most Americans don’t know what Fannie and Freddie do, many of us are in an intimate financial relationship with them involving the most important financial instrument in our lives—our mortgage—and the most important asset—our home. The way we finance housing, which makes up some 20 percent of the U.S. GDP, affects anyone who has a stake in our economy.

The idea that these little-understood but critically important companies caused the crisis is just the icing on top of the controversy about Fannie and Freddie, which were created by Congress to serve the dream of the United States as a society of individual homeowners. The two are essentially giant insurance companies. They stamp mortgages made to American homeowners with a guarantee that they’ll pay the principal and interest if the homeowner can’t. Their stamp makes it possible to package the mortgages backed by homeowners’ monthly payments into securities, which are then sold to investors, who otherwise wouldn’t want to bet their money that you and I will pay in full and on time. For years, although Fannie and Freddie had all the trappings of normal companies—shareholders, boards of directors, stocks that traded on the New York Stock Exchange—they were also, in part, government agencies, with a congressional mandate to foster homeownership. Everyone always believed that if there were a crisis, the government would rescue them. Critics hated their government-granted political and financial power, their structure—wasn’t it impossible for them to serve both shareholders and homeowners?—and the very idea that the government needed to be involved in the housing market.

Most people who weren’t paying close attention probably date the beginning of the global financial crisis at September 15, 2008, the day Lehman Brothers declared bankruptcy. But a few days earlier, on September 6, the U.S. Treasury put Fannie Mae and Freddie Mac into a status called “conservatorship,” a kind of government life support system hooked up because the rapidly swooning mortgage markets had put Fannie and Freddie in mortal peril, and their failure would have caused global economic chaos. The Treasury gave Fannie and Freddie an immediate $200 billion line of credit.

The conservatorship was orchestrated by Hank Paulson, then secretary of the treasury, who told President George W. Bush in a meeting at the Oval Office that it was, in essence, a “time out.” According to the rhetoric in Washington at the time, that time out was supposed to end with the death of Fannie and Freddie and the creation of some better, less conflicted, more pure way of financing homeownership. “This is an opportunity to get rid of institutions that shouldn’t exist,” said Paul Volcker, the revered former chairman of the Federal Reserve, in 2011. Said President Barack Obama in 2013, “I believe that our housing system should operate where there’s a limited government role, and private lending should be the backbone of the housing market.”

And yet, here we are in 2016, and—surprise!—the companies are still very much with us. The Dodd-Frank Wall Street Reform and Consumer Protection Act, which was supposed to reshape the financial sector and which President Obama signed into law in the summer of 2010, quite deliberately did not deal with Fannie and Freddie. Nothing has happened since then, either. The GSEs remain wards of the government. As the longtime housing analyst Laurie Goodman wrote in a 2014 paper, “The current state of the GSEs can best be summed up in a single word: limbo.” It turns out that solving the problem of Fannie and Freddie is the most difficult problem of the financial crisis.

Meanwhile, the mortgage market in the United States has effectively been nationalized, too. In fact, it is precisely the opposite of what President Obama said he wanted. According to Goodman, from 2008 to 2013 the government, mainly in the form of Fannie and Freddie, was the major source of credit for most people who got mortgages in the five years following the crisis. This trend hasn’t changed. Goodman recently noted that the “private label” market—mortgages packaged into securities by Wall Street, rather than by Fannie and Freddie—which hit $718 billion in 2007, plunged to $59 billion in 2008 and has not been above $64 billion since.

Nor have Fannie and Freddie shrunk. They still have some $5 trillion in securities outstanding. By one important measure, they are in more precarious shape than they were in the run-up to the crisis: thanks to a 2012 amendment to the terms governing their conservatorship, the government is taking almost every penny of profit that the two companies generate, so Fannie and Freddie have not been allowed to rebuild any capital, which could absorb losses in the event of another downturn in the housing market. “The two mortgage funders are effectively federal bureaucracies, stripped of their independence, with basically zero capital, but still dominating the market for mortgage financing,” wrote the conservative pundits Alex Pollock and James Glassman in a recent Politico piece. “We are faced with running this business with really no cushion. It is a challenging situation for us,” Fannie Mae CEO Timothy Mayopoulous said on a conference call in early 2015. “It’s the last unsolved issue of the financial crisis, and the ramifications are enormous for everyone,” says Ryan Israel, a partner at a hedge fund called Pershing Square.

Not only is the issue unresolved, signs of movement toward resolution are few. The omnibus spending bill President Obama signed in December contains a provision effectively preventing the administration from taking any action, and leaving it up to Congress. And the issue has barely been mentioned by any of the 2016 presidential candidates.

This broad silence reflects the genuinely thorny nature of the problem, but also the fact that virtually everyone in Washington supports “solutions” that are ideologically or politically convenient but don’t make sense as policy. Tea Party Republicans favor killing off Fannie and Freddie and replacing them with nothing—a move that will, at best, hand the mortgage market over to the big banks and, at worst, crater the housing sector. The Obama administration and establishment types in both parties support eliminating Freddie and Fannie but replacing them with … something else. Something perfect! Something that preserves all the benefits provided by Fannie and Freddie, but eliminates the old controversies and doesn’t create new ones, and, oh, by the way, the money to fund this something will miraculously appear, and Fannie and Freddie’s existing $5 trillion in liabilities will miraculously disappear, without any unpleasant ripples. A third option, which no one in Washington supports openly but all do operationally by their own inaction, is to keep Fannie and Freddie as they are: crippled government cash cows that will have to be bailed out (again) with the next (inevitable) cyclical decline in home prices.

There is, however, a fourth option: fix the flaws in Fannie and Freddie and let them operate, as they did—effectively—for more than half a century, as the main public-private guarantors of the thirty-year mortgage. This idea might sound sensible to most Americans. But in Washington it is considered, if not completely insane, then at the very least a political nonstarter. Yet it does have some backers, including certain reform-minded financial analysts, think tank scholars, civil rights groups, lobbyists for small banks, and, curiously, a few hedge fund billionaires who bought Fannie and Freddie stock low and stand to make a killing if the companies are revived. While this odd assortment of players isn’t getting much of a hearing right now, their idea has one advantage over all the others: it would actually work.

Freddie or not: Conservatives unfairly scapegoated the two government-sponsored behemoths for the financial crisis.

It’s impossible to understand why Fannie and Freddie are such a difficult problem to solve without going back to long before the financial crisis—even before anyone had thought to invent mortgage-backed securities.

Homeownership is deeply ingrained in the American psyche, in part because our politicians have always stressed its importance. But for most of the early years of our history, the government wasn’t involved. There were huge ups and downs in real estate, and great variability in the cost and the availability of credit. By the 1920s, mortgages were typically three to ten years in length, and required high down payments—sometimes as much as 50 percent. Homeowners often only paid off the interest, not the principal, so the mortgage had to be repaid or refinanced at maturity in one big “balloon” or “bullet” payment. If someone lived on the West Coast, they might pay double the rate of a person on the East Coast, where more lenders were based.

The Depression, which set off a vicious circle of plunging home prices and lack of access to credit, made a historically bad situation seem completely untenable. By the peak of the Depression, the national delinquency rate was 50 percent, according to David Min, an assistant professor of law at the University of California, Irvine, and lenders—primarily mutually owned building-and-loan societies—were failing in large numbers.

And so the government stepped in. After President Franklin D. Roosevelt took office in 1933, Congress passed the National Housing Act, which created the Federal Housing Administration. The FHA offered to insure lenders against defaults on long-term mortgages with low down payments. It was meant to calm everything down by encouraging lenders to lend—after all, the government bore the credit risk—and borrowers to borrow, by offering them certainty about the interest they would owe, and a long time to pay back the money. In 1936, the FHA reported to Congress that “the long term amortized mortgage has gained nation-wide acceptance at uniform lower interest rates in all sections of the United States.”

The National Housing Act also included a provision that created privately owned national mortgage associations that would buy the new FHA-insured mortgages from lenders. It wasn’t enough for lenders not to have to worry about borrowers defaulting. If they also knew that they could instantly turn their loans into cash, they’d be even more willing to lend. The associations were supposed to be funded by private capital, but in the three years after the new associations were authorized, none were set up. So to demonstrate proof of concept, in 1938 the FHA helped set up a government-owned entity to buy the loans it guaranteed. This entity soon became known as the Federal National Mortgage Association, or FNMA—or Fannie Mae.

In its sponsorship of a congressionally chartered company to help increase homeownership, the United States was, and is, unique. Around the world, the most common mortgage product is a shorter-term adjustable-rate mortgage. Indeed, the rest of the world offers no evidence that you can have a mortgage market like that in the U.S., with long-term, fixed-rate loans, without some sort of system that guarantees risks investors don’t want to take.

For consumers, mortgages are commonplace, even mundane. For investors, they are dangerous—very dangerous. Dick Pratt, who was the first president of Merrill Lynch Mortgage Capital, used to say, “The mortgage is the neutron bomb of financial products.” Mortgages come packed with risks, including credit risk (the risk that the homeowner won’t pay), interest rate risk (the risk that the lender will earn less on the mortgage than it could get investing its money elsewhere if interest rates rise), and prepayment risk (the risk that a homeowner will pay off a mortgage much earlier than expected, thereby forcing the lender to replace a high-paying asset with a lower-paying one). Of those risks, the one that most investors like the least is credit risk. The longer the term of the mortgage, the more risk there is for the lender. And so it’s come to be conventional wisdom that a fixture of American life, the thirty-year fixed-rate fully prepayable mortgage, would not exist for the wide swath of American consumers but for the presence of companies like Fannie and Freddie, which remove the credit risk and disperse the interest rate and prepayment risk to a wide set of investors. The only other country in the world that offers such a product is tiny Denmark.

It wasn’t until the 1960s that Fannie was reborn as what it was originally supposed to be—a private company with all the trappings like stock that could be bought and sold. This was done because in 1967, during President Lyndon Johnson’s administration, a budgetary commission recommended that the debt of agencies like Fannie Mae be included in the federal budget. Adding to the federal debt was no more palatable then than it is today, and so, in 1968, when Johnson signed the Housing and Urban Development Act, he effectively split Fannie in two. The Government National Mortgage Association, or Ginnie Mae, stayed in the government, and guaranteed the credit on only FHA and Veterans Administration mortgages. Fannie Mae, which sold stock to the public, was allowed to guarantee mortgages made to the great American middle class—and its debt stayed off the government’s books. “I was in the government when Fannie Mae was a government-owned institution,” Paul Volcker later told the interviewer Charlie Rose. “And it was created to take care of the mortgage market in times of stress. It was privatized for extraneous reasons. It was privatized to get it out of the budget. Ridiculous.”

At the same time, no one wanted to risk hurting Fannie’s ability to grease the mortgage market. And so the 1968 legislation also gave Fannie some special advantages. One was that the U.S. Treasury was authorized to buy up to $2.25 billion of Fannie’s debt, thereby sending a signal that this was no ordinary company, but rather one that had the support of the U.S. government. Thus began what Rick Carnell, an assistant treasury secretary in the Clinton administration, later described as a “double game.” What he meant was that while Fannie and Freddie were ostensibly private companies, their debt was viewed by investors as being akin to U.S. treasuries, because everyone believed that, if necessary, the U.S. government would bail them out. This was called an “implicit guarantee,” because it wasn’t written down anywhere and didn’t officially exist.

In the ensuing decades, Fannie and Freddie (which was created in 1970 at the behest of the savings-and-loan industry, which wanted their own company to which they could sell mortgages) became two of the largest, most powerful companies in the world. What triggered it was a Wall Street invention—a new way of financing homeownership by packaging up mortgages as securities. The Big Short shows how a Salomon Brothers trader named Lewis Ranieri made the once-stodgy business of selling bonds into a sexy, high-octane gusher of profits, and, while this is true, the real story is a bit more complicated. In essence, Ranieri needed Fannie and Freddie’s guarantee to make investors willing and able to buy his new securities. For a long time, theirs was a mutually beneficial competition, but it’s not as if Wall Street was ever happy about having Fannie and Freddie siphon off some of the profits in the mortgage market. “Wall Street had a love-hate relationship with them,” says one mortgage industry veteran.

But Wall Street couldn’t do much, because Fannie and Freddie had the ear of politicians who saw how fostering homeownership could help them, and the decade of the 1990s was, at least on the surface, a golden age. Although there was some regulatory pressure, Fannie’s political power helped ensure that the regulator was weak and the companies’ capital requirements were low. (The companies were also obligated to make sure that certain percentages of the mortgages they guaranteed went to lower- and middle-income homebuyers, a requirement that later became the key source of the controversy over their role in the financial crisis.)

The mortgage market exploded in size, from just under $3 trillion in 1990 to $5.5 trillion by the end of the decade. Fannie and Freddie, by setting the standards for what kinds of mortgages they would guarantee, effectively determined the sort of mortgage that much of the American middle class would get—and, of course, they took a toll, in the form of a guarantee fee, on every mortgage that passed through them. By the end of the 1990s, Fannie Mae had become America’s third largest corporation, ranked by assets. Freddie was close behind. The companies were ranked one and two respectively on Fortune’s list of the most profitable companies per employee. Fannie, in particular, became known as a place where Democratic operatives went to make fortunes.

The profits were not just from the business of stamping mortgages with a guarantee. In addition, Fannie and Freddie began to hold the mortgages as investments on their own balance sheet. Because of that “double game,” they could make money on the difference between higher yield of the mortgage portfolio and what their cost of funds was. The “big fat gap” is what Alan Greenspan, the very powerful chairman of the Federal Reserve for almost two decades, who became one of the GSEs’ most powerful enemies, took to calling it.

Greenspan wasn’t their only enemy. Bill Maloni, Fannie’s longtime chief lobbyist, used to call the ideological opposition to the GSEs’ very existence the “vampire issue,” because it couldn’t be killed, try though Fannie might. Economists disliked the hidden subsidy in the form of the implicit guarantee. And increasingly, other players in the mortgage industry—the banks and mortgage insurers—were angry about the extent of the profits that Fannie and Freddie were siphoning off.

The Chairman: Franklin Raines went from balancing Bill Clinton’s budget to playing political hardball as head of Fannie Mae.

For most of this period, Fannie and Freddie were able to shut down the opposition to them. Under the leadership of Jim Johnson—whom the Washington Postdescribed in a 1998 profile as “one of the most powerful men in the United States,” followed by Franklin Raines, a former financier who, as the head of the Office of Management and Budget in the Clinton administration, got great credit for balancing the budget, and who people once thought could be the country’s first black president—Fannie Mae developed a reputation for playing political hardball. “Fannie has this grandmotherly image, but they will castrate you, decapitate you, tie you up, and throw you in the Potomac,” a congressional source toldInternational Economy magazine in the late 1990s. “They are absolutely ruthless.” Gene Sperling, who was the director of the National Economic Council in the Clinton administration, used to joke, “If you think a bad thought about Fannie and Freddie, you can hear the fax machine going.” When Richard Baker, then the Republican congressman from Louisiana, began trying to get new, tougher regulation of Fannie and Freddie passed, Fannie squelched it.

The political power had a backlash. Even some of those who might have been expected to be on the GSEs’ side were offended by what they saw as their abuse of power. “The GSEs brought out a conservative side of me,” says Sperling. “The thing that turned me, that made me unwilling to do anything personally for them, is when you see that dynamic where a company is completely dependent on the U.S. government for their profit and they spend so much money and time focused on lobbying the U.S. government. It really gets kind of sick.” The fact that executives like Raines and Howard made tens of millions of dollars only heightened the anger.

But in 2004, a scandal over the accounting at Freddie, and then Fannie—over the charge, essentially, that Raines, Fannie CFO Tim Howard, and other executives had manipulated their companies’ results to please investors—led to the decapitation of the top executives at both companies. The long-standing, slow-burning resentment of the two companies exploded into the open. Fannie’s regulator even called Fannie a “government sponsored Enron.” And yet Fannie’s executives were never criminally charged, and in 2012, after eight years, sixty-seven million pages of documents, and testimony from more than 150 witnesses, a civil suit against Howard, Raines, and another executive ended with the federal judge dismissing all the charges and concluding that there was no evidence that either Raines or Howard had purposefully tried to deceive anyone.

The result was a complete tangle: Fannie and Freddie’s stable management was gone; their institutional reputations were badly tarnished; but no one among the GSEs’ many critics had the nerve—or the political support—to create anything positive out of the mess. So the GSEs rolled on, deeply wounded, with thin levels of capital and ever-more-onerous requirements to make riskier loans as the mortgage market entered its most dangerous period in history.

The Adviser: Gene Sperling, who worked in the Clinton and Obama administrations, said Fannie and Freddie “brought out the
conservative side of me.”

By the mid-2000s, so-called subprime lending, which had started in the 1990s, was taking over the industry. The mortgages were sold to Wall Street, not to Fannie and Freddie; within the industry, another term for subprime was “nonconforming,” because the mortgages didn’t conform to the GSEs’ standards. As an executive from a major subprime lending company called New Century told Congress in early 2004, subprime lenders were necessary to the economy, because they provided credit to “customers who do not satisfy the stricter credit, documentation, or other underwriting standards prescribed by Fannie Mae and Freddie Mac.” He went on to point out that while over 40 percent of New Century’s loans were made to borrowers who didn’t have to verify their income, Fannie and Freddie “have more stringent income documentation guidelines.”

Indeed, as subprime mortgages proliferated, and were sold to Wall Street, Fannie and Freddie were rapidly becoming irrelevant. Their market share fell from 57 percent in 2003 to 37 percent in 2006, according to data gathered by the Financial Crisis Inquiry Commission, which was tasked with investigating the causes of the 2008 financial crisis. A 2005 internal presentation at Fannie Mae noted, with some alarm, “Private label volume [meaning mortgages that were sold to Wall Street, not the GSEs] surpassed Fannie Mae volume for the first time.”

If Fannie and Freddie had stuck to their original business—guaranteeing mortgages made to people who (mostly) could pay—there would have been no reason for a bailout. There will always be people, including Frank Raines and Tim Howard, who will insist that if the seasoned executive teams at the GSEs hadn’t been ousted just as subprime lending was crescendoing, history would have been different. There is no way, of course, to prove that.

One piece of evidence would seem to point against it, which is that even before the accounting scandals, both Fannie and Freddie had begun acquiring hundreds of billions of Wall Street’s private label securities as investments that they would own on their own balance sheets. They did this both because the securities seemed to be a profitable investment at the time, and because—in an incredibly perverse twist enabled by regulators—these loans counted toward the congressionally mandated goals to guarantee loans made to middle- and lower-income people that Fannie and Freddie had to meet.

But it wasn’t until after their executive teams were ousted that the GSEs also began guaranteeing supposedly less risky, unconventional mortgages, like so-called stated income loans, in which the borrower simply states her income. They did this because they were under immense pressure from all sides, particularly shareholders, to win back the market share they had lost. In a presentation for a 2005 executive retreat, Tom Lund, who was then the head of Fannie’s single-family business, put it this way: “We face two stark choices: stay the course [or] meet the market where the market is.”

As the financial crisis gained steam in 2007 and 2008, Fannie and Freddie’s regulator continued to tell the market that everything was fine. “The companies are safe and sound, and they will continue to be safe and sound,” said Jim Lockhart, the Bush appointee who by then ran the agency that regulated the companies, in the spring of 2008.

But at the same time, the government was quietly pressuring the companies to raise capital. Between the start of 2007 and the summer of 2008, Fannie and Freddie sold a combined $22 billion in so-called preferred stock, bringing their total outstanding preferred stock to $34 billion. (Preferred stock pays a dividend like a bond.) The buyers, at least initially, were individual investors in search of dividends, and community banks, who were encouraged to hold GSE securities to bolster their own capital. This preferred stock would turn out to be a huge problem for the government.

By the end of the summer, their stock prices were plummeting, and it was becoming harder for them to sell the debt they needed to fund their operations. On September 5, Paulson pulled what he later called an “ambush.” At Freddie, executives were in New York for board meetings when then CEO Dick Syron received what another executive calls a “nasty gram” from Lockhart, taking back all the things the regulator had just said about the company being safe and sound, and instead leveling a host of charges at it. They were told to come to Washington for a meeting at five p.m. on September 5th at the regulator’s offices. They had no idea what was coming until they walked into the fourth-floor conference room, where they had all been many times before, and saw not just Lockhart but also Paulson on his left and then Federal Reserve chairman Ben Bernanke on his right. There was a provision in the law that if the directors agreed to conservatorship, they were immune from legal action by shareholders or creditors, making it difficult for them to do anything but agree. The management teams were told to go, and both Fannie and Freddie had to immediately fire all their lobbyists. Paulson later called the decision to take over Fannie and Freddie the “most impactful and the gutsiest thing we did.”

In a recent piece in the New York Times, Gretchen Morgenson noted that the bailout terms were “draconian” compared to those soon offered to the big banks. The government got the right to take 79.9 percent of the common stock of both Fannie and Freddie. Why not just nationalize them and take 100 percent? “If the U.S. government were to own more than 80 percent of either enterprise, there was a sizable risk that the enterprises would be forced to consolidate onto the government’s balance sheet,” explained the analyst Laurie Goodman—meaning that the federal government’s debt could skyrocket. Although the Treasury would provide no up-front cash, it committed to putting in a great deal of money—up to $200 billion—as needed over time. Fannie and Freddie would have to pay a 10 percent interest rate on any funds the government advanced. Any money the Treasury put in would become senior preferred stock, which would have to be paid before any investor in either the preferred stock that had just been sold or the GSEs’ common shares got anything. Although these shares continued to trade, their worth plummeted to pennies.

Of course, these were the shares that community banks had just been encouraged to buy (while the regulator was saying Fannie and Freddie were safe). The Federal Reserve later estimated that more than 600 depository institutions in the United States were exposed to at least $8 billion in investment losses from these securities, and that at least fifteen failures resulted. “In effect, for the small lenders serving Main Street, it was let them eat cake,” wrote the Independent Community Bankers of America in a letter addressed to the Wall Street Journal’s editorial board. “Treasury’s takeover [of the GSEs] is crafted to protect the giant players.” What the ICBA meant was that big Wall Street banks had billions of dollars in derivative contracts with the GSEs, so their failure would have ricocheted through the banking sector. But small banks? They could be sacrificed.

Things quickly got worse for the GSEs. During the presidential race between Barack Obama and John McCain, the charge, mostly promulgated by Republicans, that the GSEs were the sole cause of the crisis, and Wall Street just an innocent bystander, first emerged. McCain called Fannie and Freddie “the match that started this forest fire.” It got so bad that Freddie employees were told not to wear anything with a corporate logo, and the company offered its top executives twenty-four-hour security protection. In the spring of 2009, Freddie’s acting CFO committed suicide.

The appeal of blaming the GSEs was, and is, obvious—it’s a way to blame Democrats for the crisis, because, thanks to Johnson, Raines, and others, Fannie was regarded as a Democratic company. And, of course, if the GSEs caused the crisis, and Wall Street is blameless, then no new regulation is needed, and we can repeal the Dodd-Frank financial reform bill.

But that narrative isn’t supported by the GSEs’ loss of market share as subprime lending took off, or by the loss figures. According to an analysis by the Financial Crisis Inquiry Commission, mortgages turned into securities by Wall Street defaulted at a rate that was almost four times higher than comparable mortgages guaranteed by the GSEs, making it awfully hard to argue that the GSEs led a race to the bottom. Nor is it true that loans made to lower-income borrowers caused the crisis. A study published by the National Bureau of Economic Research in early 2015 found that the wealthiest 40Â percent of borrowers obtained 55Â percent of the new loans in 2006—the peak year of the bubble—and that over the next three years, they were responsible for nearly 60Â percent of delinquencies.

In Washington, it’s far from clear that the real lessons matter. “I wish it was simply a matter of telling the truth,” says John Taylor, the president of the National Community Reinvestment Coalition. “This is a political issue. It means you don’t have to rely on facts. You can make up your own.” “People have a visceral reaction to [the GSEs],” marvels one longtime mortgage investor. “People want to say ‘I killed them.’â€‰”

The Failed Assassin: Tennessee Republican Bob Corker sponsored bipartisan legislation that would have killed Fannie and Freddie, but it never passed.

So if everyone wants the GSEs dead, and they were such a bad idea, why aren’t they dead? “Making policy on this was one of the hardest things by an order of magnitude for the administration,” says a former official. “The danger is that it leads to all kinds of narratives that feel good but ultimately don’t lend themselves to reality. It’s fucking terrible to explain to the public. Both the politics and substance are much more complicated than anyone expected.” He adds, “And if you get the substance wrong, it could be really problematic. This is a major segment of the economy supporting the major asset most Americans have.”

One of the narratives, which is appealing to those on the right, is that we can get the government out of the housing market with the flip of a switch. In 2013, Jeb Hensarling, the Tea Party Republican representative from Texas, authored a bill that would kill the GSEs and, with the exception of some support for very low-income housing, not replace them with anything. While no one knows for sure what would happen—Fannie Mae has been around since the 1930s, after all—most analysts and market participants agree that the downside is that a great swath of the middle and lower classes probably would get five- to fifteen-year mortgages with floating rates, rates that would vary significantly depending on income and geography. Homes would be less affordable, so housing prices would likely fall. Consider that with interest rates at 3.75 percent, a $200,000 home with a 20 percent down payment and a ten-year fixed-rate mortgage on the remaining $160,000 would have a monthly payment of $1,521. With a thirty-year fixed-rate mortgage, the monthly payment is $752. Mortgage capital might be hard to come by in times of stress. Under the new system, not much would change for wealthy borrowers, but the effect on lower- and middle-income Americans could be significant.

A recent paper by the University of Chicago economist Benjamin Keys shows that when mortgages are guaranteed and turned into securities by the GSEs, the interest rate that borrowers pay doesn’t vary much from region to region, even if the economic health of those regions varies. In contrast, the cost of mortgages that are securitized by Wall Street varies much more and is less predictable. This is because the GSEs, with their national reach, engage in cross-subsidization so that, say, borrowers in a struggling region aren’t hit with higher mortgage costs.

Whatever the appeal of the “free market,” the housing industry, including the real estate agents and the home builders, still has enough clout to scare politicians about the consequences destroying their businesses. In addition, even right-wing politicians are afraid of being accused of decimating homeownership opportunities for their constituents. Real estate agents, who are fairly evenly split between Democrats and Republicans, came out against Hensarling’s bill, and it went nowhere.

There’s a deeper problem with the purportedly free market approach. Barring a total restructuring of our whole financial system, getting rid of the GSEs would turn over the mortgage market to the biggest banks. But they were bailed out in 2008, too. Dodd-Frank may have addressed (if not fully fixed) the “too big to fail” issue by, for instance, demanding higher capital requirements on larger institutions. But if such big banks control the nation’s mortgage market, does anyone think they’ll be allowed to fail in the next crisis? In which case, how are they not government-supported entities, as well? Not to mention entities whose political power would make the old Fannie Mae look like a pipsqueak.

There’s an argument, most prominently made by the think tank Bipartisan Policy Center as well as some former administration officials and analysts, that we should be able to put in place a perfect new system, one without Fannie, Freddie, or big banks. “It is simply not true that we are forced to choose between one system dominated by Fannie Mae and Freddie Mac and another dominated by a few huge banks,” wrote Jim Parrott, a former administration official who now consults for various financial services companies, including Bank of America, and Mark Zandi, the chief economist at Moody’s Analytics, who also serves on the board of a large mortgage insurer. (“A Revolving Door Helps Big Banks’ Quiet Campaign to Muscle Out Fannie and Freddie” was the headline of another recent piece by the New York Times’s Gretchen Morgenson.) Newspapers with editorial desks that are opposed to the GSEs, including the Washington Post, often opine on how this “new system” will simultaneously get rid of the GSEs, preserve access to affordable housing, not give control to the big banks, and protect taxpayers. In short, nirvana!

It would be nice if we could achieve nirvana in housing finance. But if it is possible, no one has shown precisely how it would work. With the housing finance system, the devil is often in the missing details, and the one bill that Congress did seriously undertake (a bill that was supported by both Parrott and Zandi) shows how difficult those details can be. In 2014, bipartisan legislation sponsored by Tennessee Republican Bob Corker and Virginia Democrat Mark Warner passed the Senate Banking Committee. The legislation would have killed Fannie and Freddie but preserved a government backstop for the mortgage markets in the form of a new entity. Small lenders were opposed to the bill, because despite reassuring language about how this wasn’t a big-bank giveaway, they viewed it as precisely that. Affordable-housing activists opposed it because while it offered subsidies for the poor, it did nothing for the bulk of lower- to middle-income Americans because it didn’t offer the cross-subsidization created by the GSEs. The housing finance expert Joshua Rosner, who is a managing director at the research consultancy Graham Fisher, noticed that although there was a requirement that private capital bear risk ahead of the government, in the fine print there was a provision that the requirement could be waived—meaning that in bad times, all the risk would go to the government. And, of course, the government was still backstopping the mortgage market. While some in the Obama administration, most notably Gene Sperling, who was then serving as the director of the National Economic Council, worked hard to pass the bill, the administration as a whole didn’t put its weight behind it—President Obama didn’t make any calls to senators who were on the sidelines. The bill ultimately stalled.

Supporters of the bill insist that it is fundamentally different from the current GSE system—but the key component, which is a government backstop, would remain. Says one Wall Streeter about the bill, “It’s like ripping up the whole national highway system just to build another one next to it.” We take for granted the functioning of the highway system, just as we take for granted that the price we’re quoted for our mortgages is going to be in place when we go to the closing—indeed, that the mortgage will be available at all. Even if an untested new system eventually worked, there would for sure be glitches along the way.

As a large aside, neither this bill nor any other proposal has addressed how to capitalize the new system, or what to do with the existing $5 trillion in GSE securities, 15 percent to 20 percent of which are in the hands of foreign banks.

The Co-conspirator: Virginia Democrat Mark Warner joined Corker in trying to take down the GSEs.

In short, it’s easy to say we should kill the GSEs until you start thinking about the alternatives. This is why Frank Raines used to say privately in the wake of the crisis, “We might call them Dick and Harry, but give it ten years, and there they will be.”

Keeping Fannie and Freddie in any form is an outcome to which many, including the Obama administration, are furiously opposed. Some of it is due to the widespread belief that the bailout of Fannie and Freddie proves that their business model was fatally flawed, even though many of the people who say this don’t say the same thing about the big banks. Some is due to the legitimate fear that any entity that has access to any type of government subsidy (even if the guarantee is explicit, rather than implicit), and that operates in an area as politicized as homeownership, will inevitably become corrupt. Some of it is due to the personal animus toward the GSEs that exists in much of Washington. “When they were in their prime, they rolled over a lot of people in [Washington],” one closer observer says. “Now, people are getting even. There’s a lot of that out there. I don’t care which side of the aisle you’re on.” And some of it is due to the power of the idea that the GSEs’ low- and middle-income housing goals were solely responsible for the crisis.

But some of the opposition to Fannie and Freddie is, ironically enough, a direct function of who it is that is pushing for it. Surprisingly enough, it is some of the most powerful hedge funds in the country.

You might recall that when the government took over the GSEs, they left roughly 20 percent of the common shares outstanding and trading, as well as that preferred stock that had been sold in the run-up to conservatorship. Despite the rhetoric surrounding the GSEs, Lockhart even said that the goal was to return Fannie and Freddie “to normal business operations” and that “both the preferred and common shareholders have an economic interest in the companies … and going forward there may be some value in that interest.”

The Profiteer: After making nearly $4 billion from shorting subprime securities, John Paulson bought up shares in GSEs.

In the dark years following the bailout, the GSEs appeared to be racking up tens of billions of dollars in losses. But some investors noticed that the situation wasn’t nearly as dire as it appeared. Under the terms of their bailout, Fannie and Freddie were required to draw money based not on current cash losses or needs, but on when their net worth fell below zero. Net worth is an accounting concept that takes into account estimates of future losses, so Fannie and Freddie were required to draw money based on estimates that they would lose billions in the future. But these estimates turned out to be way too high.

In addition, the bailout forced Fannie and Freddie to pay a 10 percent dividend back to the Treasury on any money they took. Because the dividend payment further reduced their net worths, they had to draw additional money from Treasury to fill the hole created by the dividend payment. According to a FHFA official, around $45 billion of Fannie and Freddie’s $187 billion bailout consisted of draws that took money from Treasury only to round-trip it right back to Treasury to pay the dividend. “It was a complete payday-lender situation,” says someone close to the situation.

Ultimately, Fannie Mae took almost $116.2 billion and Freddie Mac $71.3 billion from the U.S. Treasury, a total of $187.5 billion. One analysis done on behalf of a major investor shows that most of the losses were caused by non-cash charges such as provisions for loan losses that didn’t materialize. During the period in which the GSEs lost money, from 2007 to 2011, the provisions for losses exceeded the actual losses by $141.8 billion. According to this analysis, the combined equity deficiency of the GSEs was really only about $10 billion.

A handful of investors realized that when accounting rules required that the estimated losses be reversed, the GSEs would post staggering profits. And so they began buying up those preferred shares, which were still priced near zero. Some of them, like the hedge fund Perry Capital, had made fortunes betting against, or shorting, subprime mortgages in the run-up to the crisis. Paulson & Co., run by John Paulson, who made almost $4 billion from shorting subprime securities, bought shares. So did a hedge fund run by the Carlyle Group, a politically connected Washington, D.C.-based private equity firm. “We expected the political rhetoric,” says one investor. “We thought, ‘It’s easy for you to say you want to kill them, and that they are an endless black hole.’ But once they were profitable, we thought the rhetoric would change.”

Rhetoric aside, conservatorship is supposed to be governed by the law, which in essence says that the conservator must either “preserve and conserve” the GSEs and release them back, or throw them into receivership, in which case their assets would be distributed to shareholders. The investors argue that even a few years after the crisis, there were sufficient assets that the preferred stockholders would have gotten all the money they were owed.

But then on August 17, 2012, a sleepy summer Friday, Treasury and the FHFA changed the rules of the game. Going forward, instead of paying a 10 percent dividend, Fannie and Freddie would be required to send every penny they made to Treasury. If everything went to the government, then there was no value left for investors. Both the common and the preferred shares plunged in price.

The official explanation for this change is that the administration had no idea that the GSEs were about to become so wildly profitable, and so they executed the sweep of profits to prevent the GSEs from owing money they couldn’t pay. The sheer amount of money the GSEs started making immediately following the sweep makes it hard to believe this.

Another explanation is that the change in the deal came a year after the huge fight in Congress over raising the debt ceiling. Since that time, battles over spending have become commonplace. The profits generated by Fannie and Freddie, which go straight to Treasury, have at critical times helped buy breathing room, or, as Treasury Secretary Jack Lew said in recent congressional testimony, “As a practical matter, it’s what has helped us to reduce our overall deficit.” Thanks to the GSEs’ profits, federal spending was underreported by a combined $178 billion in 2013 and 2014, according to a paper by the Heritage Foundation. Not incidentally, there is no accountability for how the profits from Fannie and Freddie are spent; and once the money is spent, it is gone and cannot be used to buffer any losses they might suffer again.

Eventually, investors, including Perry Capital and Fairholme Capital Management, which manages around $10 billion on behalf of some 180,000 individual investors and a few institutions, sued. To date, around two dozen lawsuits have been filed, some of them by big investors, but others by individual stockowners and pension funds like the City of Austin Police Retirement System. What’s happened in the courts is a drama all its own, but the upshot is that it is impossible at this stage to guess what the outcome might be.

But the lawsuits are in some ways a sideshow to the question of what should be done with the GSEs, and this is the real battleground. What some investors really want is a stake in a recapitalized, albeit reformed, version of Fannie and Freddie, which, they argue, is the right solution—as well as one that would increase the value of their stock.

In response, the Obama administration has made it clear that they will not bring Fannie and Freddie back in any way, shape, or form. Officials refer derisively to the investors’ plans as “recap and release,” meaning that the GSEs would be allowed to build capital, and then we’d send them back out, exactly as they were before the financial crisis. At the Mortgage Bankers Association’s annual convention in October, Michael Stegman, former counselor to the secretary for housing finance policy at the Treasury and now senior policy adviser for housing at the White House, said recapitalizing the companies would be “turning back the clock to the run-up to the housing crisis.” He added that investors had bet big that the companies would be allowed to exit conservatorship “and they are doing everything they can to make sure those bets pay off.” Other officials speak in broad terms about “comprehensive housing finance reform.” As Antonio Weiss, the counselor to the secretary of the treasury, wrote in a recent op-ed, the administration “wants to transition to a better system, one that provides broad access to housing supported by a sound and robust mortgage market, without exposing taxpayers to another rescue.” Once again, nirvana! But, of course, without any details.

One reason for the unwillingness to consider any plan that releases Fannie and Freddie is that politicians don’t want to give up the stream of money flowing into Treasury from the GSEs. It’s also clear that the administration does not want to see investors get paid. (A Treasury official even wrote a memo to then Treasury Secretary Geithner before the 2012 profit sweep citing the “administration’s commitment to ensure existing common equity holders will not have access to any positive earnings from the GSEs in the future.”)

But everyone involved in the housing finance debate—most notably, the big banks that this administration has done so much to protect—has money at stake. Stegman has repeatedly referred to the “failed” GSE business model. But the idea that the GSEs failed relies on inflated loss figures. And if the bailout means the business model failed, then what about the big banks? Isn’t theirs a failed business model too?

The real issue isn’t whether investors get paid. It’s whether we have a housing finance system that makes sense. The investors aren’t the only ones who would like to see Fannie and Freddie reformed rather than eliminated. These include civil rights organizations like the NAACP, who are worried about the plunge in minority homeownership rates since the crisis; affordable-housing advocates, who worry what the world will look like without the GSEs (this summer, the Census Bureau reported that the homeownership rate had fallen to 63.4Â percent, the lowest level in forty-eight years); and community banks and other small lenders, who don’t want to lose all their business to the big banks.

The Reformer: The author and analyst Josh Rosner has proposed a solution that would treat GSEs like utilities.

The best idea, whose most prominent backer is Graham Fisher’s Josh Rosner, is that the GSEs would operate as utilities, much like your electric utility, with a cap on the return they are allowed to earn, and regulated as such by a competent regulator with real teeth. The regulator, as Rosner writes, would “ensure that the firms employ their benefits of scale to minimize the costs to end-users while allowing them to earn acceptable, rather than excessive, rates of return.” They would be somewhat like the GSEs were in the 1980s, before all public companies faced inordinate pressure to grow their earnings and please investors. They would be well capitalized at a level consistent with that of other large financial firms, and they would no longer be able to hold mortgage securities on their own balance sheet. (Their portfolios of such securities have already shrunk dramatically.)

Rosner also writes that it is important that the GSEs serve as “countercyclical providers of liquidity.” What he means is that if the market is going crazy, and Wall Street is happily providing mortgage capital, the GSEs can and should stand back. That way, they will have dry firepowder if there are problems, and private capital flees the market. There’s already a taste of how that might work. Today, the GSEs are selling a portion of the risk they insure to other investors. The current way the GSEs sell risk is not without its flaws, but it is a start to doing exactly what President Obama said he wanted, which is getting private capital in front of the government.

This idea isn’t perfect, especially if you believe any government involvement in business opens the door to eventual corruption. It also requires regulatory competence, which is something that has been in short supply in modern times.

One of the major objections is that there’s a conflict inherent in the GSE business model, in which they are publicly traded companies that owe a duty to investors, but also have a congressional mandate to encourage homeownership. Critics say that it is impossible for a company to serve two masters. The utility structure would alleviate the issue, in that investors in such a business wouldn’t be looking for turbo-charged growth, but rather for stability, but the two masters would remain.

But it’s also worth asking whether this conflict is truly the problem that critics make it out to be. There are a lot of evolved companies today that talk about “stakeholder value” instead of “shareholder value.” Indeed, you can argue that the monomaniacal focus on shareholder value hasn’t served our markets so well. Isn’t there a counterargument in which the two mandates—serving homeowners, but with a focus on the bottom line— balance each other? After all, a company with a duty to homeowners but without any responsibility to shareholders could be very dangerous indeed. The bottom-line responsibility, at least theoretically, not only keeps the companies conscious of the risks they are taking but also helps attract a different sort of employee than a pure government bureaucracy might attract. And that is important. The mortgage market is fierce and fast moving. The old Fannie and Freddie could hold their own with Wall Street traders, who are looking for any and every opportunity to make money from slow-moving government institutions. We do not want companies that are completely neutered to serve in this role.

It is true, though, that some wrinkles would emerge in this business model. While requiring the GSEs to get rid of their portfolios will make them less risky, it also means that they will be less profitable, which in turn means less money for affordable housing. While some investors say privately that they support the utility model—and it’s worth noting that there are none who advocate for a simple “recap and release”—it’s also not clear what sort of value owners of the GSEs’ common stock would be able to extract from this model. It’s quite possible that the odd alliance between investors and affordable-housing groups would break down in a bitter fight over who gets what piece of a much smaller pie.

But for citizens and taxpayers, it’s the right answer. We know that the basic infrastructure of the GSEs works, and worked well for fifty-plus years. On the other side, the argument that we shouldn’t settle for something less than perfect sounds a whole lot less compelling once you realize that no one has any vision of perfect, let alone any plan to get there, nor any clue about what glitches or outright corruption might emerge in a new model. And there’s this: all the talk about “comprehensive” reform is just empty words. Now, reform is in Congress’s hands, and one industry lobbyist says that everyone in Washington knows that after the failure of Corker-Warner, the chance that Congress will act is nil. All the words are a pretext for doing nothing.

Yet there’s also a risk to doing nothing. It’s impossible for the private market to resume functioning, even if it can, until the government decides what its role will be. More importantly, because the government has been taking all their profits, at this point the GSEs have less than $5 billion in equity supporting their more than $5 trillion in liabilities, leaving them with a capital ratio of 0.1 percent. To put that in context, when the Federal Housing Administration, which is fully owned by the government, had its capital fall below 2 percent, there was a political uproar over the potential loss to taxpayers. Indeed, the situation is painfully ironic in that the widespread belief is that capital is the one thing that makes the system safer. The largest banks are now required to have a capital ratio that is close to 5 percent. If there’s a recession and housing prices fall again, or if there’s a big swing in interest rates, Fannie and Freddie would have to be bailed out by taxpayers again. Don’t we deserve more of a plan than that?

In The Big Short, there’s a moment when Ryan Gosling tells the audience that he knows this stuff is really complicated, and it seems easier not to care, but that’s really dangerous, because what you don’t know can hurt you. When it comes to housing finance, Americans’ best interests have rarely dictated the answer, precisely because too few people care. That’s another thing the movie got right.

Bethany McLean is a contributing editor at Vanity Fair and the author of Shaky Ground: The Strange Saga of the U.S. Mortgage Giants (Columbia Reports, 2015), from which this article is adapted.